December 30th, 2011
The last day of trading for calendar year 2011 is upon us. The market is set to close around the flat line for the year and if someone had gone to sleep late December of 2010 and woke up today, he or she would perhaps think that it was a snoozer of a year! As we know, that could not be further from the truth. The market has traded within a relatively wide range and the overseas headlines have dominated the market action almost from day one. There were natural disasters such as the earthquake in Japan and consequent tsunami as well as the Arab Spring which combined with the European debt debacle and our own domestic economic and political woes made for a very difficult trading year.
Nonetheless, we did have some success particularly early in the year and during this the 4th quarter of the year. Late spring and summer was difficult for most traders and we took some serious lumps as well.
Heading into 2012 we are making no major changes to the TOFI – Options strategy in general. I believe that we have found the sweet spot in regards to the metrics used for autotrading the strategy such as maximum number of live positions etc as well as our own internal trading parameters and systems. I feel very good about the strategy going forward!
We are going to formally suspend the Leveraged ETF strategy for the time being and just concentrate on our diversified options trading strategy. The leveraged ETF space is the current “redheaded step child” of the market and I believe the regulators are going to eventually step in and change how these instruments are designed and used by traders. The intraday volatility that these instruments have created continues to be scrutinized and perhaps rightfully so.
From the pure perspective of the trading strategy, the decaying aspect of the leveraged ETFs make them little more than day trading instruments in the current market where day to day strong ups and downs in the price action can exacerbate the decaying effect of these instruments. Since our strategies do not revolve around day trading, I feel best to shut down the ETF strategy for the time being and perhaps revisit later in the year.
When I started this newsletter back in 2007, my goal was to provide my subscribers an alternative trading philosophy to what has been the norm for many years. The main principle behind the philosophy is that risk management can only be accomplished on an absolute basis by limiting exposure to it in the first place. There are many brokers, newsletters, pundits and other assorted investment related professionals who profess that the way to success in the market is to diversify between asset classes and invest for the long run. There are also many in the marketplace who make claims that there are ways to structure positions in options, futures etc which offer “high probability” of success (90%+) and that by trading only these high probability trades, one can generate outsized returns.
This fallacy has cost many traders a bunch of money over the years…These high probability strategies do work well most of the time if applied properly. The issue is that because they are high probability trades, when they do go wrong, they generate very outsized losses. Many traders get into a false sense of security and sometimes have months (years) of positive but meager returns only to give it all back in one single bad month. Because these strategies are large risk versus small reward propositions, when a Black Swan event, which by definition are not “knowable” events, the losses can be devastating.
Over the past several years, the stock market has undergone tremendous changes to its core structure. The abolition of the Glass Steagall Act which prevented financial firms from operating as banks and brokerage/insurance companies at the same time has added a great deal of leverage to the system and has exposed many participants willingly or not, to a tremendous amount of risk. The advent of advanced technology which today is used by some firms to “game” the current market system is also something that has forever changed the landscape for traders and investors alike.
Because of these factors, I wanted to offer subscribers an options trading strategy that was high risk high reward using my directional trading models and signals which could be applied to a small portion of an individual’s portfolio yet generate sufficient alpha to outperform portfolios composed of much higher dollar amounts invested in diversified broad market sectors while offering a lower overall risk profile. The first year we were in business, our trading strategy generated returns of over 285% and we were the highest yielding, verified options trading newsletter in the country. This generated much interest and our subscriber base grew extremely fast as many traders jumped on board . The issue we run into is that very often, individuals become mesmerized by the return potential of options but disregard the risks associated by allocating very large amounts (in relation to their overall portfolio) to the strategy in hopes of “hitting it big”….
As many of you know, I do not believe in owning equity in the form of stocks. This hasn’t always been the case but for the past 10 years, I have not owned a single stock. The reason for this is not that I do not believe in the earnings power of good solid companies but because I don’t believe in the structure of the marketplace where these instruments trade. Like I mentioned above the market has changed and the risk versus reward of owning equity in the form of common stocks of even the best companies is not a compelling proposition in my opinion. As I have often mentioned, I keep a large majority of my investable assets in “riskless” assets comprised of different duration/maturities of United States Treasury bonds bills and notes. The remainder is dedicated to our options strategies and that amount never surpasses 25% of the overall portfolio. Gains in the trading is capitalized monthly and a portion is used to supplement my income and a portion is reinvested proportionally between the “riskless” account as I call it, and the trading account. This is by no means a recommendation, it is what works for me and I present it so that you as a subscriber to my newsletter are aware of what is at stake in regards to my overall level of assets. Undoubtedly someone managing a position that represents 2.5% of their investable assets is going to perhaps take a bit more risk than someone who is managing a position that represents 25% of their assets….
I often get many questions regarding investing in Treasuries and why I would park money in such low yielding instruments. The truth is that most do not understand the mechanics of the bond market and the dynamics that govern it. The bond market is not the equity market…The bond market is not nearly as affected by what ails the equity markets today. In fact, long term (80 plus years) returns between the bond market and the equity market are almost identical at around 5% per year with a much lower risk profile.
The idea is that the treasury portfolio is there to provide a backstop for my trading when the trading account is diminished by positional losses. I want to have the greatest portion of my assets in instruments that have a stated maturity and that are guaranteed as far as return of principal and interest are concerned. I know that the term “riskless” is viewed as nonsense by many today due to the current state of affairs but the debt of the United States is still the safest bet in financial markets.
This again is not a recommendation but just me sharing what has worked for me, personally, over the years. In short, please make sure to keep your allocations to manageable levels for your particular financial situation. Over the years I have had thousands of subscribers who have learned and applied this philosophy/strategy to their own situation and today are successfully trading options on their own and beating the market year in and year out.
I want to thank you all for your support and for your business. I look forward to a profitable 2012!
Wishing you and yours a safe, happy and prosperous New Year!
December 29th, 2011
The light volume and concerns over Europe combined for a lower session. The weakness occurred early on and the majority of the session was spent trading sideways, digesting the losses. The weak Euro was to blame for the day’s weakness but perhaps more importantly, the US dollars strength was what brought the knockout blow for commodities and stocks in general. Financials also suffered some weakness after a week or so of recovery strength.
The session’s internal readings were negative with breadth decisively to the downside with declining issues outpacing advancing issues by a 6-to-1 margin. The index losses were all in the neighborhood of 1%. Volume was a bit heavier than Tuesday’s level, but still well below average. Again, there isn’t much insight to be garnered from those numbers. It is basically just a low volume down day to follow up what has been a series of low volume up days.
As we pointed out earlier, the odds of getting a big move up or down before year end seem unlikely. With the S&P 500 at resistance, the internal momentum measures closing in on overbought levels and the lack of participation typical of this time of the year, a push through the resistance area seems difficult if not improbable. After a few days of strength and resistance looming, it is not unusual to see some profit taking. The S&P levels of importance remain the 1265-1275 range on the upside with 1200-1225 the near term support range. The S&P 500 and the other major indexes are in a bit of no man’s land for the time being.
The GLD is trading sideways today after the lower opening gap and actually has managed to pare the loses quite a bit as the session progresses. The open was ugly in the Gold pits and there was a major rush to the doors to take advantage to profit taking in what is one of the few assets up for 2011. The options market activity was also interesting. The at the money volume in the Jan Call strikes was nearly three times the ATM put volume and even now as I write this note, it is 2 x 1 over put volume.
The IWM in turn is rebounding today after yesterday’s move lower. The broad market SPX is fighting for a close at the flat line for the year and I think that is exactly what we are going to get. We are going to hold steady here and take the 2 current positions into the New Year.
December 27th, 2011
The end of year, seasonal grind higher seems to be in full force although the pace of this push may get even slower as we negotiate the 200 day moving average. From a technical perspective, we have to watch out for several factors that may come into play at the 1265 to 1275 SPX level. Besides the 200 day, this general level bumps up against the lower highs made on the downtrend channel formed back in May of this year. This are also coresponds to the first standard deviation from the 40 day short term moving average studies. All three of these could act as a some form of resistance particularly as we trade on such light volume.
Some in the market may interpret this low volume/resistance combination as a great setup to go short the market but after 4 trips to this resistance level on a narrowing range, the market is set to move one way or another and early Jan money flows may push us above this resistance point which could be the catalyst needed to get some participation after the new year.
The opposite scenario, say we fail at this level, could bring us to support at the 40 day moving average which at the moment is at the same general level as the widely followed 50 day MA at around 124 SPY.
It is very difficult to get a short term directional picture at this late stage of the year. Many participants will not be back until early January and those who needed to cover shorts have already done so making any technical study handicapped at best.
I still favor a move higher into the first couple of weeks of January before pairing back a bit. This move higher should take us to test 1300 or the upper band of the second standard deviation from the 40 day MA. We could see a push to 1320 or so but that should be about all before a move lower to retest some lower levels around 1220 or slightly lower but not pushing below 1200. Following the corrective move lower, we could set up for a stronger push into mid February where we could perhaps even push as high as SPX 137 to challenge the highs of 2011. From there I believe we will again enter a period of lower lows and lower highs and the market may begin to falter again.
Headlines from Europe will continue to roil markets and the potential announcement of a QE3 program from our own Fed will obviously have a bearing on how markets trade. Many participants are anticipating the Fed to step up again to make a stronger effort in helping to push unemployment lower.
We closed out the XLE position today. The sector is still favorable in my opinion but decay on the January options will require sharper and sharper moves higher in the price of XLE in the next few days to offset and I think we may begin to slowdown into the New Year holiday. We will certainly revisit this sector again early in the year.
Gold has traded a bit lower still and the bounce I anticipated has really faded quickly. This may be due to just miserable trading volumes or there may be more downside in the metal. At any rate I am not going to wait around too long for this one to perform and more than likely close it out before year end. IWM will more than likely be taken into 2012 and If we are to rally, this may be the sector to ride.
December 22nd, 2011
Stocks have managed to hold their ground after some awful earnings from tech bell weather Oracle. The firm rarely misses earnings projections and the fact that the market managed to hold its positive bias yesterday and today despite the poor showing from the broad technology sector is encouraging.
Overall the session was benign and a flat day after a 3% gain the previous day isn’t all that concerning particularly this time of year. The session managed to keep the momentum of Tuesday’s rally intact and as I mentioned, a day or two of consolidation after the “monster” rally is perfectly normal.
The S&P 500 should make a solid push higher to at least the flat on year level of 1257, but more than likely make a push to test the 1265-1275 resistance levels. Should the S&P manage a few days of calm into next week and into year end, it is possible that the broad market index will knock on the door of 1300.
Energy continues to show some bullish divergences particularly against the broad commodities sector. The energy sector has broken from the general broad commodities sector as Oil looks poised to make a push to the upside. This divergence is being viewed as supporting the outperformance of the domestic economy as well as other developed economies versus economies of emerging nations. Since developed economies consume the majority of crude oil supplies, it stands to reason that outperformance of stocks from developed economies may last at least into the first half of next year.
Gold seems to have stabilized after a corrective move lower to test long term resistance which has so far held. The move lower has brought GLD back to an interesting point to consider long plays. If we consider the chart below, we see that the exhaustive move higher of late July into October has been worked off and we are again testing the lower band of the uptrend channel formed in early 2009. I expect this channel trading pattern to continue into next year which should give us plenty of trading opportunities. This next leg higher should take us to at least 162/165 on the GLD and eventually into the low 170’s before pulling back again.
The domestic economy continues to improve. The jobless claims number continue to improve and there are signs that consumers are spending a bit more. Housing starts have also improved and are at recovery highs. Overall consumer sentiment is surging higher and although still very pessimistic by historical means, it nonetheless has improved substantially over the past month. The improving conditions should begin to take some of the luster away from U.S. Treasury prices as we tread into 2012.
Wishing all of you a very happy and joyous holiday season and a very merry Christmas!
CJ Mendes
Tuesday, December 20th, 2011
The market continued its drift lower yesterday after the third test of the recently established downtrend line. Today, we have managed to build some momentum off of a benign overnight trading session in Asia and Europe and with one of the two major gaps closed, traders are feel a bit better putting some cash to work.
There have been some signs in the intra-day studies that traders were buying into the very recent weakness and this was particularly the case with the XLE and the SPY. This divergence is what gave us an indication that perhaps there was some “stealth” accumulation going on in the S&P futures market that would be expressed in the cash markets once this gap closed. Below is an hourly chart of the XLE and a 15-3-3 stochastic oscillator along with a superimposed buy/sell volume oscillator that makes this a bit clearer. The arrows point to the divergence so that we see prices dropping but that there is accumulation building as the red volume oscillator line pushes higher above the mid point. This basically shows that traders were “buying the dips”.
I have gotten a lot of emails on this today and I wanted to share the reason or better said, what I was looking at yesterday and why I picked up some more XLE calls at the point I did yesterday. There is method to my madness!
On the same chart, we can see that today’s opening created a short term gap against the prevailing short term trend which may very well be closed tomorrow. The push today has taken us exactly where this downtrend pattern has indicated it would making a new lower high. A day of strength tomorrow following today’s rally would be a solid indication that some more accumulation is going on which is what we want to see develop in the next few weeks until at least the first days of the new year. If we manage to make a closing high and break the downtrend altogether, the rally may pick up even more steam.
As I mentioned above, this is the first of two prominent open gaps for most equity ETFS that remain open. The other is the initial opening gap off of the short term oversold levels of late November. This gap will be closed as well at some point… On the SPY, this happens at the 116.77 level for example and on the XLE, it is at the 64.10 level. My feeling on this is that we will not push lower here and the reason for this is the divergence I mentioned above. It seems that, barring some unknown event hitting the market, accumulation has begun and we should begin making a series of higher highs and lower lows off of the trading action today.
C.J. Mendes
cjm
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